Starting earlier, compounding longer, and compounding better are key principles, or key pillars of personal finance that help grow wealth over time.
Here’s how to apply them:
Start Earlier
Start saving and investing as soon as you can.
The most significant advantage you have is time.
The earlier you begin, the more time your money has to grow through compounding.
Even small, consistent contributions made in your twenties can grow into a substantial amount by the time you retire, potentially surpassing larger contributions made later in life.
This is due to the power of compounding.
Compound Longer
Keep your money invested for as long as possible.
Compounding is the process of earning returns on both your initial investment and the accumulated returns from previous periods.
The longer your money is invested, the more powerful this effect becomes.
For example, if you invest $500 per month for 40 years and earn a 7% average annual return, your total contributions would be $240,000, but your portfolio would be worth over $1.2 million.
The majority of that growth comes from the later years as the compounding effect accelerates.
The key is to resist the temptation to withdraw your money early and allow it to compound uninterrupted.
Compound Better
Aim for a higher rate of return.
To “compound better,” you need to increase the rate at which your money grows.
While higher returns often come with higher risk, you can improve your compounding in a few ways:
- Choose the right investments: Investing in a diversified portfolio of low-cost index funds or exchange-traded funds (ETFs) is a common and effective strategy. These funds offer broad market exposure and have lower fees than actively managed funds, which can significantly eat into your returns over time.
- Reinvest dividends and capital gains: When your investments pay out dividends or capital gains, reinvesting them automatically buys more shares, which then earn their own returns, creating a powerful compounding loop.
- Automate your savings: Set up automatic transfers from your checking account to your investment account. This “set it and forget it” approach ensures you consistently invest, regardless of market conditions or personal discipline.
- Maximize tax-advantaged accounts: Utilize accounts like a 401(k) or IRA to their fullest potential. Contributions to these accounts often grow tax-deferred or tax-free, which means you don’t lose a portion of your returns to taxes each year, allowing for more powerful compounding.